Today, I'll share with you a simple system that makes money in oil...
If you had invested $10,000 in this simple system about 25 years ago, it would have turned into $63,000 today, versus $23,000 for buy-and-hold.
Even better, you could teach a monkey to follow it, and it would only take maybe 12 minutes a year.
This system has nothing to do with predicting wars in oil-producing countries, or forecasting economic growth. It has nothing to do with oil supply and demand... inventories... buying or selling from commodity funds... or anything else that's supposed to affect the price of oil.
The only "prediction" we make here is essentially that bodies in motion will stay in motion... that the trend last month will be the trend next month.
That's all this simple system is at its heart. At the end of the month, if the price of oil is above its 10-month average, you buy it for the next month. At the end of the next month, you do the same thing. Lather, rinse, repeat.
Take a look at the results in the graph below... You're in oil when it's green. You're out (and in cash earning interest) when it's red.
You can see this simple oil system captures the big "up" moves in oil... More importantly, you are out for the big downtrends.
Oil has risen 3.3% a year since 1984. But when oil is above its 10-month moving average – when this simple system is in "buy" mode – oil has risen at a compound annual rate of 9.1% per year. And when it's below the 10-month average, it's lost money at a compound annual rate of 3.7% per year.
This signal doesn't flash that often... For most of 2007 and 2008, it was in "buy" mode. And during that time, the price of oil doubled, from $65 to over $120. In late 2008 through early 2009, it was in "sell" mode, and oil crashed to around $40. In May 2009, it kicked into buy mode again, and stayed there for a year. Oil soared to over $80.
In the last four months, the signal has flip-flopped a bit. The current signal says it's a bear market in oil – a mode where oil loses 3.7% per year.
What's so magical about the 10-month average? Nothing, actually...
You could have used whatever longer-term moving average you like. You can make it much more complicated... using trailing stops, for example. But the point is to be a part of the big trend.
I like the 10-month average "system" simply because it keeps you in the big trend... and not just in oil. It works across a variety of assets and a variety of time frames.
The 10-month average is what my friend Meb Faber used for his system that has beaten the stock market since 1973 without a losing year (OK, it lost 0.6% in 2008). He simply did this 10-month-average strategy for five different asset classes (U.S. stocks, foreign stocks, bonds, real estate stocks, and commodities). If the asset was above its moving average, he owned it for the next month. If not, he sold it.
The only snag with this simple system when you apply it to oil is that it's hard to directly trade the price of oil...
A pretty good way to own oil in your investment account is through DBO, the PowerShares fund that attempts to track the price of oil (but it doesn't do so exactly).
If you want to create a fancy model for the oil price – one that somehow factors in geopolitical risk, speculators, economic growth, and whatever else – be my guest. It is true that a huge stew of factors cause the price of oil to move.
But that fancy model would probably have a hard time beating this simple little system that takes a minute a month to follow...
Right now, it says oil is in a bear market. Trade accordingly.
